CITI: The bond market is littered with landmines

Citigroup strategists led by Stephen Antczak have a 25-page note out on the outlook for credit in 2016, and one of the key themes for the year ahead is deteriorating fundamentals at investment-grade companies.

"Compared to a year ago the balance of risks has shifted to the downside, whether we're looking at landmine potential, the supply backdrop, or the evolution of corporate fundamentals," the note said.

The median debt-to-earnings before interest, tax, depreciation and amortization ratio for non-financial and non-utility bonds has spiked in the past few years, according to Citigroup (figure three below).

In simple terms, that means that companies have taken advantage of the low-interest rate environment to pile on debt, with the most creditworthy companies now averaging a debt-to-earnings ratio of 2.1, compared with around 1.6 in 2006.

The cause for concern, according to Citigroup, is that the trend of adding debt is playing out in parallel with a decline in earnings.

"Figure 4 shows that over the last several quarters, growing leverage has been a result of the combination of rising debt and falling EBITDAs. To our minds, the concern here is that increasing leverage could be more dramatic than it has been in recent years - both the numerator and the denominator are now under pressure."

Citigroup

Citigroup describes this as a "fundamental weakness" that will translate into more downgrades, and that in turn will lead to more fallen angels, a term for companies which were once investment grade but are downgraded to junk status. The number of downgraded companies now exceeds upgrades ones over the last-twelve months.

"Although this measure is backward looking, we do see downgrades as a preeminent risk in '16. In fact, we expect the trend to intensify in the period ahead," Citigroup said. "We are particularly concerned with the potential for falling angels."

The US bank estimates that as much as 1.5% to 2% of the investment grade universe could go to high-yield, or somewhere between $60 billion and $100 billion of bonds. "That's a lot of fallen angels," the note said.

The process of becoming a fallen angel can be painful for investors and the companies alike: many investors can only hold investment grade bonds, which means there is forced selling ahead of a potential downgrade to junk. That pushes the cost of credit up for the companies.
Citigroup

The Citigroup note also points to a broad increase in volatility across the market. Figure 33 below shows the number of 90-day drawdowns in the high-yield market over 15 years. These drawdowns are defined as moves of 100 basis points or more. In the pre-Lehman Brothers era, there were four such drawdowns, two of which were in the wake of the dot.com crash.

"In the post-Lehman era - a period characterized by, for the most part, positive GDP growth and low defaults - we have already experienced eight major drawdowns."

There are also more often sharp moves in individual high-yield bonds. Citigroup found that 226 bonds rallied by five basis points ore more in October, and 243 bonds fell by five basis points or more in November. Around a quarter of these were the same bonds that rallied the month before.

"Did the fundamental backdrop really change that much in a month? If not, that's a considerable amount of mark-to-market risk to wear, in our view," the note said.